The Oser View

Capsule Summary

Several economic reports released this morning provide a capsule overview of the economy.  The Commerce Department reported that consumer spending increased a meager 0.1% in June as high gasoline prices, falling home values, and a weak dollar took their toll.  Spending on big-ticket items in general and automobiles in particular fell sharply.  Inflation, however, remained tame.  The Personal Consumption Expenditure (PCE) Index, excluding food and energy, inched up rose 0.1% for the fourth consecutive month.  The PCE, which the Fed considers the most accurate inflation gauge has risen just 1.9% over the last 12 months.  This is the smallest year-over-year increase since March 2004; more importantly, it is finally within the Fed’s inflation comfort zone of 1-2%. 

A gloomy report on home prices in 20 metropolitan areas indicated that housing problems are not near abating.  Only five cities enjoyed year-over-year price increases.  The Detroit area is suffering the most.  Home prices there have declined 11% since May 2006, and the pace of decline is accelerating rapidly.  The annualized depreciation rate for the last three months exceeds 20%.

An index of businesses conditions in the Chicago-Detroit area was also disappointing as new orders, production and order backlogs fell from previous months’ levels.  The key here is that if domestic consumer spending falls off, economic expansion, if it is to continue, will have to driven by business investment.

Today’s final report was consumer confidence, which surprisingly reached its highest level in six years.  Less than 15% of those surveyed think economic conditions are “bad,” and less than 20% think jobs are “hard to get.”  More than 30% think jobs are “plentiful,” and barely 8% believes business conditions are about to get worse.  The persistently low unemployment rate, stable—though high—gas prices, and June’s dramatic stock market gains are believed to be the drivers.

On Friday, the Labor Department will provide the June employment numbers.  With that data in hand, we will be in a better position to consider what will happen—or not happen—when the Federal Open Market Committee meets next week.

Playing Poole

      “The punishment has been meted out to those who have done misdeeds and made bad judgments,”' Poole told reporters in St. Louis after a speech on the market for mortgages to borrowers with sketchy or weak credit histories. “We are getting good evidence that the companies and hedge funds that are being hit are the ones who deserve it.”

The “Poole” quoted above by Bloomberg News is not a televangelist inveighing against the money changers in the Temple.  He is the President of the Federal Reserve Bank of St Louis.  Another of Mr Poole’s interesting beliefs is that the problems sparked by non-performing subprime mortgages are not spreading to the wider financial services industry. 

Try telling that to the holders of bank stocks.  Large, small and in-between bank stock indices hit 52-week lows today as did many individual names. Or try telling it to corporate bond managers who are experiencing sharply falling prices for all but the very best credits. Or try telling it to the wizards of private equity. 

Just this month, Henry Kravis, one of the first and most famous practitioners of the leverage buyout, was quoted by Bloomberg Magazine, “The private equity world is in its golden era right now.  The stars are aligned.”  Not any more.  JP Morgan Chase reported yesterday that the issuance of Collateralized Debt Obligations, into which the loans and bonds that finance buyouts are often securitized, declined from $42 billion in June to less than $4 billion this month.   To put this in context, the two biggest buyout firms—Kohlberg, Kravis & Roberts and the Blackstone Group—must raise $300 billion in the next few months to pay for acquisitions that have already been announced.  And that does not include the more than $30 billion that must be placed this week to finance two huge privatizations, Chrysler and Alliance Boots, the UK equivalent of Walgreen’s.

The markets thought the subprime mortgage problem was contained following the demise of the most egregious lenders early this year and the subsequent tightening of underwriting standards.  Then the markets thought the problem was contained when the collapse of two large Bear Stearns hedge funds did not seriously harm the firm or its lenders.  (The investors, of course, lost everything.) Today’s stock market plunge and accompanying “flight to quality” Treasury buying shows that the problem is still far from contained.  And that brings us back to the Fed.

The Fed has painted itself in a corner by holding the fed funds rate at 5.25% for the last year.  Its claim that core inflation—up just 2.2% year-over-year—remains our most pressing economic problem is becoming harder to justify every day.  Liquidity is rapidly draining out of the system, and while the elimination of excesses is necessary, the long-term harm could be substantial.  JP Morgan Chase warns that “with home prices dropping and credit tightening, most of the borrowers of the roughly $500 billion of ARMs scheduled to reset over the next 18 months will probably be unable to refinance.”  The Fed should start thinking seriously about lowering the fed funds rate.  Opinions like Mr Poole’s only make the process more difficult.         

Fortune's Wheel

How ironic and what a strange turn of Fortune’s Wheel that the most financially sophisticated Americans are likely to suffer the greatest pain from loans made to the least financially sophisticated Americans! The loans in question are subprime mortgages, which are defined as loans made to individuals with credit score of 620 or below. A subprime mortgage borrower has, in addition to a low credit score, high debt to income and loan to value ratios, on average 42% and 87% in 2006.

Last year marked a watershed in subprime lending. Interest rates were rising, which normally restricts mortgage affordability especially for marginal borrowers. But a huge, loosely regulated infrastructure of mortgage brokering and securitizing had evolved in the fat years of 2003-05. The machine had taken on a life of its own, and it reacted to changing conditions by relaxing its already none-too-tight underwriting standards. The result was an enormous volume of adjustable rate mortgages to first-time homebuyers who put no money down and often were not even required to document their incomes. This so-called "affordability product," masked under the socially desirable rubric of bringing homeownership to those previously shut out, is at the heart of the subprime problem.

Approximately 20% ($600 billion of $3 trillion) of mortgages originated in 2006 are considered subprime. Of these, nearly three-quarters are adjustable rate mortgages or ARMs. As of March 31, 2007, 15.75% of all adjustable-rate subprime mortgages were delinquent; 10.1% were seriously delinquent; 6.5% were in foreclosure. The year-over-year increase in the delinquency rate of subprime ARMs was 373 basis points; the rate of seriously delinquent loans jumped 211 basis points.

A brief look into asset securitization will help clarify how low-income ARMs became a headache for high-income investors. Wall Street can and has turned any predictable stream of cash flows into securities, the key word being "predictable". Mortgages, with their low delinquency rates and steady monthly payments, have proved to be ideal for securitization since the first Ginnie Mae pools were issued in 1970, but many other asset classes will do. Today, a typical securitized mortgage or asset-backed securitization (not Agency-guaranteed) looks like this:

Once loans are securitized, defaults and losses are absorbed from the bottom up, first in the unrated or equity piece, then in the B, BB, BBB tranches and so on up the credit ladder. These ratings are bestowed by Moody’s, Standard & Poor’s, and/or Fitch. Their input and analysis is critical, and the relationship between the rocket scientists who build the more exotic derivative investment products and the rating services is symbiotic. Securitized mortgage bonds are built to achieve desired levels of ratings for their various tranches. The ratings, in their turn, are based on models of historic performance of the underlying mortgages.

Obviously, the more complicated the instrument, the more critical the need for good historic data. That’s why the earliest Collateralized Debt Obligations (CDOs), which are repackages of existing securities, were built from corporate bonds, where decades of historical performance were available. CDOs differed from MBS in that the risk of ebbs and flows of cash flow streams was exchanged for the credit risk of ultimate repayment, but the same structure of tranching was retained. In the last few years, more and more securitized subprime mortgages and home equity lines (HEL) found their way into CDOs. Citigroup estimates that in 2006, the entire $50 billion of BBB-rated securitized HEL debt was absorbed into CDOs.

Despite the rating services’ disclaimers and warnings, investors often rely so heavily on credit ratings that their investment policies require them to sell bonds that fall below certain levels. Of course, savvy investment managers have been trying to sell subprime MBS and CDOs for months, but the rating service downgrades could well force a fire sale. Moreover, the downgrades are a tacit admission that historical data was insufficient to model the risk associated with these securities, and this means that nobody really knows where the bottom is. The equity pieces, BB, and B tranches of many subprime CDOs are already worthless. We were reliably informed of a BBB tranche, purchased last year at 99, which sold recently at five cents on the dollar. It’s probably not an aberration.

These dislocations have caused "flight to quality" Treasury buying, reduced appetite for credit risk in corporate bonds, and wider spreads in some callable debt. Broadly, investors are re-valuating their appetite for risk, which seemed all-but-unlimited just a few months ago. We expect prepayments of all mortgages to slow, causing the average lives of MBS to lengthen, at least temporarily. The greater risk is if investors became nervous about Fannie Mae and Freddie Mac; that is, if rising delinquencies and foreclosures popped up in the prime loans these Agencies guarantee.

How could this happen? As noted, subprime mortgages are securitized into tranches with varying degrees of credit risk, and by 2006, CDOs had become virtually the only buyers of the riskier tranches. Following the trail backwards, if CDOs are out of the market, few subprime mortgages can be securitized, which means that fewer subprime mortgages will be originated. The whole bottom level of the mortgage market reverts to the rental market. Home values, particularly in the lower tiers, fall because potential buyers can’t get financing, and sellers can’t sell. Refinancings drop off because there is less equity to draw on. Defaults increase as homeowners stop paying mortgages whose balances are greater than the value of their homes. And then the other shoe drops.

It’s an axiom of the mortgage business that, if people have jobs, they will pay their mortgages. So far in this economic cycle, jobs have been plentiful. The unemployment rate has hovered around 4.50% for close to a year. If the subprime mess contaminates the economy and leads to job losses—in construction, in businesses catering to home improvements, in banking and finance, wherever—a vicious cycle could develop. This is the nightmare scenario and the basis for those economists predicting a recession this year or next. It’s very much a minority view. A more likely endgame is that the most significant loan problems—as contrasted to financial problems—will remain concentrated in the bottom tiers.

It’s still far too early for certainty. The mortgage world moves slowly. Payments are only made once a month, and as long as borrowers are willing to cooperate with servicers, all sorts of accommodations can be arranged. Even when foreclosure is initiated, the final disposition can take months or years. Odds are, we won’t know the full impact of the 2006 subprime debacle until 2008 at the earliest.